Insight

Price discrimination and the psychology behind it

September 2016

Price discrimination

Price discrimination is a strategy where you charge different prices across different markets for the same products or services. By adopting a price discrimination strategy you aim to charge the maximum price that your customers in a particular market segment are willing to pay.

But how do you establish how much to charge? This is where psychology plays its part.

The psychology of pricing

We all understand that a £ equals a £. This sounds simple enough, but is it true? It's true enough when we consider a £ as a unit of measurement - we all recognise that something costing £100 is more expensive than something costing £10. However, as a unit of value it can mean different things to different customers.

This ambiguity is rooted in the way our minds work. Our conscious brain processes information in a logical way but is in constant conflict with our subconscious. Our conscious brain can only process so much while our subconscious can process masses of information. Imagine the processing power necessary to design and build a machine that could catch a tennis ball yet we can accomplish this task subconsciously even though we have to judge speed, trajectory, and the exact moment the ball will make contact with the hand. Our subconscious sends only the information our conscious brain needs to focus on the activity in question.

The checker shadow illusion

Our brains are more attuned to spotting comparative difference: what we perceive can vary depending on context. Often the way we see something is not how it is.

Edward H Adelson - Professor of Vison Science at Massachusetts Institute of Technology (MIT) - published this illusion in 1995.

If, like most people, you believe that squares A and B are different shades of grey you are mistaken - they are, in fact, the same.

You may find this difficult to believe so maybe this next illustration will help.

By joining the two squares with lines of the same colour you will now see clearly that the two squares are the same.

So what is happening here? Our brains are not good at identifying things in absolute terms. Our subconscious is collating data and making some informed guesswork, filtering the results and then sending them to our conscious minds.

The same is true of pricing. While you may think that, in absolute terms, prices should be identical regardless of who is buying, when viewed in relative terms buyers' perceptions are different.

The anchoring effect

In 1974, Amos Tversky and Daniel Khaneman conducted an experiment as part of their Nobel-Prize-winning work.

They asked people to estimate how many African countries were members of the United Nations - a question to which few people would know the answer. First, participants had to spin a wheel that would give them a random number. Except the number wasn't random: all participants either spun a 10 or a 65.

Next, participants had to answer two questions:

1. Is the percentage of African nations in the UN higher or lower than the percentage you spun?

2. What do you think the actual percentage is?

There is no logical reason why participants' answers should in any way have been influenced by the number they spun but the results were quite revealing. Those who spun a 10 estimated that around 25% were members; those who spun a 65 estimated around 45%.

So although the two numbers were supposedly random they had in fact given participants a point of reference. This is the anchoring effect.

This is exactly the psychology stores use in a sale situation. How many times have you bought something in a sale and based your decision on how much you are saving rather than how much you are spending? You've used the original price as your anchor.

The anchoring effect is critical when you formulate your pricing strategy.

Perception is sometimes reality

If you accept that people will pay different prices for similar products and services simply because of the way they perceive them, it follows that you can improve your sales significantly by using a price discrimination strategy that allows customers to buy at different prices.

The context in which you place your price can make it appear good value or poor value. If you combine price discrimination and context successfully you can improve dramatically both your average price and the quantity you sell.